OREANDA-NEWS. Fitch Ratings has affirmed BT Group plc's (BT) Long-term Issuer Default Rating (IDR) at 'BBB' with a Positive Outlook. A full list of rating actions is below.

BT's ratings take into account its solid incumbent telecom position in the competitive but rational UK telecom market; its strong cash flow and conservative leverage relative to European incumbent peers and the prospect of an improved operating profile once the EE acquisition closes. This is still subject to regulatory clearance but is expected to happen in 1H16.

Fitch previously stated that the improved diversification and broader service platform that the EE deal will provide, has led to a modest relaxation in our upgrade guidelines for BT. A revised guideline of funds from operations (FFO) adjusted net leverage consistently below 2.5x would support a 'BBB+' rating, a metric that is expected to be met in the first year of transaction close, given the strength of BT's current performance and the cash flow scale of EE. Fitch therefore expects to upgrade BT's ratings once the EE transaction closes.

KEY RATING DRIVERS
Strong Operating and Financial Performance
As an incumbent telecom with a predominantly fixed line business in the UK, Fitch considers BT to be well managed, consistently delivering strong operating performance, stable revenues and increasingly strong cash flows. Through a combination of investment in its fibre network and in incumbent terms, a significant move into TV content, BT continues to gain solid broadband acquisitions, market share gains and deliver improving residential average revenue per user. This has been achieved against a background of high infrastructure competition from cable and a highly developed UK pay TV market.

The company reported FFO adjusted net leverage of 1.6x at YE15 (1.8x when adjusted ie. removing - the benefit of the EE related equity placement) with deleveraging expected to be driven by free cash flow (FCF). This metric is forecast in our EE acquisition case at around 2.1x (on a pro-forma basis) in 2016 and to reduce thereafter.

Regulatory Noise; Risks Contained
The EE acquisition is subject to Competition and Markets Authority (CMA) scrutiny, with constituent interests (competitors), raising concerns among other things, over the consolidation of available wholesale infrastructure in the UK. Ofcom's Strategic Review of Digital Communications, the first in a decade, has also given rise to calls for the structural separation of BT's (Openreach) network infrastructure; which the regulator is said to be taking seriously. Ongoing regulatory risk relates to Ofcom's margin squeeze test, which is intended to ensure a fair margin between BT's retail and wholesale fibre pricing (VULA rates).

Fitch expects that the acquisition will receive regulatory clearance; but that some remedies are inevitable. Regulatory-driven structural separation has rarely been pursued, the benefits of which are unclear. Fitch considers the regulatory environment in the UK to be transparent and that functional separation, in place since the creation of Openreach, has supported wholesale-based competition. Structural separation is not the agency's more likely expectation.

Diversified Service Platform, Market Position
The EE acquisition, if approved, will significantly improve BT's operating profile and market position. Regardless of other planned consolidation of the UK mobile market, an integrated BT/EE will combine a strong (currently leading) mobile position with one of the few European incumbents with a stable to improving domestic fixed line business. BT would be the only UK operator able to provide a quad-play bundle on controlled infrastructure. While the UK telecoms market is competitive, it has not exhibited the pressures that have characterised markets such as France or the Netherlands, or the economic pressures, albeit easing, of southern Europe.

The English Premiership League (EPL) rights auction earlier this year resulted in rights inflation of 30% for BT. This was contained given overall EPL inflation of 70%. Its European Champions League coverage begins in 2015/16 (at a cost of roughly GBP300m a season), underlining a commitment to content seen in few incumbent business models. Although content costs are therefore expected to increase materially, relative to the overall cost base and cash flow scale of the company, these costs are considered manageable.

Leverage-Friendly EE Deal Structure
The EE deal structure incorporates a significant equity component with more than half the equity value being paid for in new shares of the enlarged company. BT's underlying cash flow complimented by EE is expected to lead to pro-forma year 1 FFO net leverage below 2.5x, the revised upgrade guideline to 'BBB+'. The revision reflects the enhanced operating profile of a combined BT/EE. Fitch's calculation of FFO includes the pension deficit contributions made in line with the recovery plan agreed with the pension trustee following the 2014 triennial funding valuation. Measured on a net debt/CFO less capex metric, reducing from approximately 4.0x, the company has a conservative metric relative to its peer group.

Integration Risk, Management Track Record
As with any acquisition, there is integration/execution risk. BT's management is well regarded with a solid track record of delivering operating efficiencies, although with limited experience of running a mobile business. The transaction does not rely on revenue synergies and cost synergies do not appear overly optimistic.

KEY ASSUMPTIONS
Fitch's key assumptions within the rating case for BT include:-

- Flat to low single-digit underlying revenue growth driven by continuing strength in the consumer operations and Openreach, offsetting volatility in Global Services.
- EBITDA margin to remain broadly in the mid-30s with rising incremental content costs being offset by stable and improving retail revenues and ongoing cost efficiencies.
- Capex to remain broadly in the region of GBP2.3bn, trending down from around 13% of revenues as revenue growth evolves.
- Dividend growth to remain in line with current trends - ie. FY15 dividend growth of 14%; minimal buybacks assumed.
- While not formally factored into the rating, Fitch's working assumption is that the EE deal receives regulatory clearance and closes in 1H16.

RATING SENSITIVITIES
Future developments that may, individually or collectively, lead to positive rating action include:
- FFO net lease adjusted leverage consistently below 2.5x, which is a moderation to the previous guideline of below 2.0x and assumes the successful close of the EE deal.
- A sustained position in the highly competitive UK triple-play market supporting stable revenues, a sustained margin profile and solid free cash flow generation.
- Visibility on the cost implications of significant content rights renewal, albeit noting that EPL and European Champions league costs are known for a number of years.

Future developments that may, individually or collectively, lead to negative rating action include:
- A downgrade to 'BBB-' would be likely if FFO net adjusted leverage was expected to remain consistently above 3.5x. This represents a relaxation of the existing guideline of 3.0x and assumes the EE transaction closes.
- Deterioration in the key operating and financial metrics at BT's main operating subsidiaries, or significant risk taking in relation to the development of BT Consumer's pay-TV offering.

LIQUIDITY
Liquidity is healthy, with balance sheet cash of GBP2.6bn and undrawn bank facilities totalling GBP5.0bn at June 2015. These include the GBP1.0bn proceeds of the EE-related equity placement and a GBP3.6bn EE acquisition bank facility. Core bank liquidity is provided by a GBP1.5bn facility due 2020 with a one-year extension option.

FULL LIST OF RATING ACTIONS

BT Group plc
Long-term IDR: affirmed at 'BBB'; Positive Outlook
Short-term IDR: affirmed at 'F2'

British Telecommunications plc
Long-term IDR: affirmed at 'BBB'; Positive Outlook
Short-term IDR: affirmed at 'F2'
Senior unsecured rating: affirmed at 'BBB'.
Commercial Paper Programme: affirmed at 'F2'.